Prince: Can you give us a few examples of investment areas that you have been focused on?
Cohen: Our two overriding themes are value orientation coupled with tail-risk hedging. We have always been focused on tail risk, even before people referred to it as that. Tail-risk hedging, of course, means creating positions within our portfolio for the purpose of protecting against those outlier events in a statistically normal distribution curve. Maybe it's the engineer in me, but I believe in quantifying and measuring everything that can be measured, and I think it's important to understand and make rational decisions about what positions you own and how they might all move in a market displacement. For example, in 2007 we had no view on the level of the market but noticed that volatility was at a 25-year low. We put on a large, in notional terms, position of equity index put options that cost us very little given this lower volatility. Our view was that if the market maintained its level but volatility spiked due to some global event, this cheap insurance would pay for itself. As luck would have it, these global options appreciated during the 2008 crash when the market took a fast and violent 50% fall. So we benefitted from volatility spiking and, at the same time, from a market correction. The large profits from this trade helped to insulate the portfolio from a massive down stroke in 2008, and provide liquidity, which set us up for a big recovery in 2009. Once volatility spiked, we switched our tail risk hedging strategies to incorporate put spreads, given how expensive puts became, and also incorporate hedges on interest rates, credit spreads, currencies and commodities.
We also look for massive cyclical displacements. I have some experience from the RTC days in the early 1990s when I worked for another Forbes 400 member, an experience that gave me a feel for real estate cycles. I promised myself all those years ago that if anything like RTC 2 came along, I would have the capital, knowledge, experience and contrarian confidence to recognize it and take advantage of it. In late 2006, I got a beautiful gift in my e-mail inbox. It was the investment prospectus for what was at the time the largest real estate investment offering ever-over $5 billion: an opportunity to invest in a massive multifamily transaction alongside some of the marquee institutional real estate investors. The bankers were telling us it was heavily oversubscribed. The property itself needed a lot of freshening up, but carried a pro forma cap rate of 4% with a business plan to upgrade, increase rents and manage it better. I think they even had some "new" cash flow and income measures that I hadn't even heard of, which is always a bad sign. Warren Buffett would have called it "priced to perfection." The lights and siren went off in my mind, and it's all I could think about. We were fast approaching the frenzied top of the real estate cycle and a large correction seemed imminent! This party just smelled like it would end badly and I wanted to set up a distressed real estate team to be in front of the curve.
I immediately contacted several headhunters and started networking in the real estate community nationally. In general, I found a lot of "group think" and scores of senior real estate executives that couldn't step outside their bull market perspectives. I had a lot of real estate experience from the 1990s, but felt we needed additional bankruptcy and distressed experience. Anyway, we paced ourselves. We took over a year to hire the head of the group and then, together with him, watched for another year as the real estate market kept searching for a bottom. By the time we believed the bottom was near, we had built a highly skilled, highly professional distressed real estate team that was poised to invest. These folks are experts not just in real estate, but in bankruptcy and foreclosures, and have a great feel for the arcane science of unraveling difficult and complex capital stacks and making opportunistic buys of real estate and property loans and notes. We did eight direct deals last year. We also work with a top five bank, which has been financing us as well. We are growing that business exponentially at extremely attractive rates of returns with very low risk. We have been referred to as a "by the pound" buyer, which means we are willing to assume and box traditional risks all at a price. This theme is consistent with our overall philosophy, which is to understand and insulate from worst-case scenarios and position us well if things work.
We also have a meaningful timber investment in Central American hardwoods. This includes building one of the world's largest teak plantations, which will be an excellent investment from a rate of return perspective and is tax efficient. As important is the fact that we are doing our part to reverse climate change with the replanting of 40 square miles of grazing land that was formerly rainforest with six million new trees.
Another area we have done well in is master limited partnerships. MLPs are generally oil- and gas-oriented. We were in the sector going back to 2006 and liked the risk/reward dynamic, yield and tax efficiency. After our entry into the market, we began to see what became a flood of new investment funds specializing in this area. But when the market began to turn south on them in 2008, some of the funds experienced a "run on the bank"; investor redemptions forced them to sell. Other funds were highly leveraged and debt covenants forced them to sell, almost wildly, to stay in loan compliance. In this frenzied selling, we saw a huge opportunity unfold. We were initially a holder of LP interests, which typically trade at higher current yields, but offer lower long-term cash flow growth, than GP interests. We saw an inversion start to emerge. GP interests began to get cheaper, driving their yields up, while still offering superior upside in the long-term. At that inflection point, we began trading-selling LP interests and stocking up on GP interests. MLPs became our largest position at over 15%. This really powered our returns in the 2009 and 2010 recovery. We did really well. The benchmark Alerian MLP index, for example, was up over 70% in 2009 and 30% in 2010.
So, that's a sample of what we do. Stable capital is so important to us. For example, during early 2009, I was running around the office telling everyone that the hardest thing to do was buy and the second hardest thing to do is not sell. It was hard, but with our tail risk positions insulating us from some of the direct brunt of the economic storm, we were able to actually do both of those things. It was painful to put on more risk at that time, but the crowd did exit, some voluntarily and some less so as a result of fund redemptions, and our contrarian nature led us in the right direction.
Prince: Do you have any other thoughts you can share when it comes to investing more than a billion dollars?
Cohen: I think we are equally as proud of what we didn't do as what we have done. For example, during the 2005-2007 period, we watched the birth of many enhanced credit strategies. During that period, we didn't feel risk credit spreads accurately reflected the underlying financial and operational risks. Visitors pitching these wares wore out the carpet in our lobby, but we just stuck to our beliefs and wouldn't bite. And, of course, we are very fortunate we didn't.
We also have never been overallocated to traditional private equity, for a couple reasons. First, over the past six years, we just didn't see a significant arbitrage opportunity between the prices of private and public equities. Second, without that arbitrage opportunity, the 10-year locks didn't make much sense to us. We place more value on liquidity. Cycles are faster now, so we feel we need this liquidity.
And expanding for a moment on liquidity, it's critical to the way we work. We always feel we have to dig our wells before we get thirsty. So when the capital markets downturn began, when long-term lack of liquidity became a meaningful risk to most investors, we had a lot of cash on hand, undrawn credit lines we could tap if necessary, and prime broker and derivative relationships in place that would have been hard to establish in the midst of a downturn. And we have always been highly strategic in our use of hedges, which not only protect our portfolio, but also operate to provide liquidity when we most need it.